Week ahead: Stocks ride tailwind, but watch for rising rates

Stocks ride a strong tailwind into the week ahead, but the Fed could remain a source of nervousness if interest rates continue to rise.

A highlight of the week will be the testimony of Fed Vice Chair Janet Yellen Thursday during her confirmation hearing before the Senate Banking Committee.

Yellen has been nominated to replace Fed Chairman Ben Bernanke when his term expires in January, and while she is expected to be confirmed, traders will be fixated on her comments to see where she stands on monetary policy and how she views the economy.

The earnings season winds down in the coming week, with Wal-Mart's report Thursday. Macy's reports Wednesday and Nordstrom and Kohl's, on Thursday.

There is also some economic data on the calendar, including inflation data Thursday and Friday.

Chinese inflation data, industrial production and retail sales, released over the weekend, will be a focus early in the week.

Energy prices are likely to get a boost as the failure of high-level talks in Geneva on Iran's nuclear program dash hopes for a thaw in sanctions barring its sale of oil.

(Read more: Talks for Iran nuclear deal end without agreement)

After Friday's surprisingly strong jobs report, market focus shifted again to the possibility the Fed could start to wind down its bond buying program even as soon as December. Many economists had expected the Fed to taper back its $85 billion bond buying program in March, after Yellen takes Bernanke's place.

But the 204,000 jobs added in October and 60,000 added to August and September was strong enough to stir up speculation that if the employment picture shows continued improvement in November, the Fed will move ahead to slow its easing program at its next meeting in December. There were some negatives in the report, including a rise in the unemployment rate to 7.3 percent, reflecting the effect of the government shut down.

Bond yields immediately zipped higher Friday on the strong jobs report, with the 10-year reaching 2.75 percent, but stocks also gained with the Dow roaring 167 points higher to 15,761, locking in a 0.9 percent gain for the week. The S&P 500 climbed 0.5 percent for the week, finishing at 1770, just shy of its record.

Bernanke, speaking on a panel Friday, did not tip his hand on policy but said there is an "awful lot of slack" in the labor market and that the unemployment rate understates it, while the data does not provide an accurate measure.

"I don't think a tapering in December will be well received by the market and I don't think it's going to happen, but at the same time, we do think it has a chance and that it should not be ignored," said David Bianco, chief U.S. equities strategist at Deutsche Bank.

Bianco said the Yellen hearing will be important because the market is trying to assess not just the Fed policy on quantitative easing, but its course on policy, including how it would decide to move the target Fed funds rate. "This isn't about tapering. It's about what the right monetary policy is for the next two years…what is their view on the labor market," he said.

"She's going to say as little as possible about the future of Fed policy," said Diane Swonk, chief U.S. economist at Mesirow Financial."She's going to be out there, grilled like crazy, talking about the different tools the Fed has, but it's not in her interest to set the Fed on any pre-set course. She really is in a bit of a box. They want to hand off the transition to forward guidance. They think it might be more effective than the balance sheet but they're not all on board with it."

Swonk said some Fed members would like to pare back bond buying, which balloons the Fed balance sheet, and push out the zero rate policy on short term rates further into the future.

There has been some speculation in the bond market that Yellen will actually sound hawkish during the hearing. She is seen as a very dovish Fed official, aligned closely with Bernanke.

"There is a risk that she comes off as more hawkish than everyone thinks she is," said Ian Lyngen, senior Treasury strategist at CRT Capital. "The market's perception of her being one-sided will be challenged with the confirmation hearing, as she becomes a more vocal part of monetary policy. I think the takeaway will be that she is more balanced than she is currently viewed."

There is a group of Fed speakers in the coming week, but the Yellen hearing will be most important. While the bond market is closed Monday for Veteran's Day, traders will focus on three auctions of 3-year,10-year and 30-year Treasurys Tuesday through Thursday.

"Part of this (rate increase) is going to be a reflection of building accommodation for supply," said Lyngen, who said yields could retreat in the coming week. "This is typically the period of the year after the November refunding, where seasonals tend to be more supportive of the Treasury market."

Some traders also expect the rise in yields to be self-correcting, since the stock market and economy reacted negatively when they edged to 3 percent earlier in the fall.

What Else to Watch

The Nasdaq finished flat for the week at 3919, recovering 1.6 percent Friday, and the Russell was up 0.4 percent for the week, gaining 1.9 percent Friday. Both those indexes had been diverging, declining while the Dow and S&P rose and falling harder when they declined.

There has been a move into defensive names in recent sessions, but in Friday's rising market it was the sectors that benefit from an economic recovery that were driving gains – financials, materials and consumer discretionary, while utilities and telecommunications stocks were sold.

Traders will be watching those trends, since the selloff in the Russell and Nasdaq, which led the markets' gains, was viewed as a possible sign of a broader sell off.

"I think a lot of defensive stocks got rebid when people thought there would be another full year of QE. Telecom, utilities, they all jumped up," Bianco said. Those sectors are typically strong dividend payers and are more attractive when bond yields fall.

Bianco does not expect further gains in stocks this year, and his target is 1750 on the S&P. "I think we go sideways. I think every time we made a run toward 1800 or get close, we get knocked back," he said. Bianco said the place to be for year end is in big cap tech, and he downgraded his overweight views recently on energy and financials.

He does expect the S&P to reach 1800 but only after Congress gets past the next round of budget negotiations in the beginning of the year. He also said the market is looking for clarity on data and the Fed. "My guess is we don't get any data that shifts what the consensus view is until early next year. A lot of debates we thought would get more clearly resolved by now have been pushed into late January, early February," he said.